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SAIS CHINA STUDIES Student Working Paper Series FALL/2009 Meredith Champlin

From People’s Money to International Currency: Internationalization with Chinese Characteristics

Meredith Champlin SAIS China Studies Working Paper Series

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This paper was prepared for the course “Research Seminar: China and the Global Financial Crisis,” with

Pieter Bottelier.

Comments on this draft may be addressed to the author, Meredith Champlin: [email protected].


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Against the backdrop of the current global financial crisis, Chinese officials have urged for

reform of the international financial system, increased regulation and oversight of the financial

sector in developed countries, and expanded use of Special Drawing Rights (SDRS) as well as

China‟s currency, the renminbi (RMB or yuan). Much of China‟s concern stems from the risks

associated with its extraordinary U.S. dollar holdings. Indeed, the dollar‟s value has fluctuated

since the start of the financial crisis in September 2008. The dollar‟s decline has sparked debate

in China about how much of its reserves should be held in dollar-denominated assets (presently

estimated at about two-thirds), as well as the increasing exchange rate risk of holding a national

currency as a reserve currency. In March, Governor Zhou Xiaochuan of the People‟s Bank of

China, the central bank, issued a provocative statement calling for reform of the international

financial system to promote SDRs as an alternative to the U.S. dollar for international reserve

holdings.

At the same time, China itself has come under renewed pressure to revalue its own exchange

rate. From finance ministers in Europe and Japan to the managing director of the International

Monetary Fund (IMF), China has been criticized for reestablishing the RMB‟s informal peg to

the dollar, thereby effectively depreciating the RMB along with the dollar in recent months.1 In

response, Chinese officials have signaled that they will continue to reform the exchange rate

mechanism. Echoing the policy of the People‟s Bank of China (PBOC), Vice-Foreign Minister

Zhang Zhijun recently commented that, “China will increase the flexibility of the RMB exchange

rate at a controllable level in the future based on the market demand and with reference to a

basket of currencies.” (China Daily, November 2009) Yet, China has also urged greater

monetary policy prudence on the part of developed nations, particularly the United States. In

recent statements, Chinese officials have pressed the United States to maintain the value of the

dollar and tighten monetary policy so as to prevent a new asset bubble and ease inflationary

pressures.

Following the onset of the international financial crisis, the Chinese Communist Party (CCP) has

pushed forward two policy responses: internationalization of the RMB and reform of the

international financial architecture. This paper will assess these strategies, with particular

emphasis on the prospects for, and implications of, RMB internationalization. The first section

will briefly review Zhou Xiaochuan‟s proposal, while the second section will provide a snapshot

of the current international situation. Sections III and IV will then take a closer look at

indications of the RMB‟s internationalization in general and the regionalization of the RMB in

Asia specifically. Following this, I will provide my own analysis of the RMB‟s

internationalization. In my view, RMB internationalization faces many hurdles. Thus, China‟s

approach mirrors that of all its economic reforms, namely incremental steps coupled with

experimental phases and pilot schemes. Additionally, China has learned several lessons from the

Asian financial crisis and the current financial crisis. I assert that these lessons are shaping its

vision of financial regulatory reform and the international financial system. Finally, I will

1 On July 21, 2005, the PBOC unpegged the RMB from the dollar and revalued the yuan by 2.1 percent to 8.11 per dollar. The PBOC pursued a managed floating exchange rate based on market supply and demand with reference to a basket of currencies, and the yuan was allowed to rise or fall 0.3 percent a day against the dollar from a reference rate set every morning by the PBOC. In 2007, the yuan's daily trading band against the dollar was widened to plus or minus 0.5 percent. Following the global financial crisis, in July 2008 the PBOC informally repegged the RMB to the dollar.


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conclude my analysis with some brief observations about the implications of China‟s policy

approach.

INTERNATIONALIZATION OF THE REMINBI (RMB)

On March 23, 2009, the People‟s Bank of China released a statement by Governor Zhou

Xiaochuan, calling for the dollar‟s replacement as the dominant world currency and the creation

of “an international reserve currency that is disconnected from individual nations and is able to

remain stable in the long run.”(Zhou) Contrary to Federal Reserve Chairman Bernanke‟s savings

glut thesis,2 Zhou Xiaochuan argues that basing the international financial system on a national

currency – the U.S. dollar – exacerbated global imbalances, leading to the current financial crisis.

Also, referencing the Triffin Dilemma, Zhou cautioned the international community about the

dangers of permitting a national currency to become the dominant international reserve currency.

The Triffin dilemma states that any national monetary authority issuing the de facto international

currency will create either too much liquidity or too little liquidity. The United States, as the

reserve currency nation, must run a current-account deficit to provide liquidity to the

international monetary system. Yet, at the same time, the United States should be prudent

enough to run a current account surplus so as to maintain confidence in the dollar, or at least the

country should not run large and persistent deficits that undermine confidence in the dollar. One

proxy for how the United States is managing the dilemma is the value of the dollar in foreign

exchange markets. (Carbaugh and Hendrick) In this regard, the dollar‟s recent decline, falling

nearly 22 percent since 2002 based on the Federal Reserve‟s trade-weighted dollar index, may

signal decreasing confidence. 3

(Gongloff, November 2009) Likewise, China‟s official

statements urging the United States to protect the value of the dollar reflect a growing concern

over its own U.S. dollar investments.4

Zhou‟s statement received considerable attention both in China and internationally, stimulating

debate on whether SDRs could serve as a supra-national currency for reserves. The SDRs,

created by the IMF in 1969 to support the Bretton Woods system, were designed to be used in

conjunction with the dollar and gold for the settlement of payments deficits. In other words,

SDRs are international reserve assets used to supplement IMF member countries‟ official

reserves. While the use of SDRs as an international reserve currency never gained traction –

representing less than 1 percent of total reserves today – SDRs continue to serve as a unit of

account of the IMF and as potential claims on the currencies of IMF member countries.

(Carbaugh and Hendricks). In Zhou‟s essay, however, he proposed the following reforms to

expand the international use of SDRs: “(1) make the SDR convertible into other currencies, (2)

promote the use of the SDR for commodity pricing, investment and corporate book-keeping, (3)

create SDR-denominated tradable financial instruments, (4) update the formula used for the

2 See: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/ 3 Indeed, some go beyond Gongloff‟s estimates, for example Carbaugh and Hendrick write, “For most of this decade, the United States has struggled to maintain the dollar‟s value. Against major currencies, the dollar depreciated by about 33 percent during 2002-2009.” 4 Pieter Bottelier writes, “Although [Zhou Xiaochuan‟s] proposal may have been partly motivated by domestic politics, it does reflect deep-rooted concern in China that the international financial crisis and subsequent U.S. responses to it could undermine the purchasing power of the dollar.” (Bottelier, China Brief, May 2009)

http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/


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allocation of new SDRs by the IMF, (5) update the valuation base of the SDR by including other

currencies in its base (presumably including the RMB)5, and (6) promote confidence in the value

of the SDR by shifting from a purely unit-of-account or calculation-based system to a system

that is backed by real assets such as a reserve pool.” (Bottelier, April 10, 2009)

In addition to calling for greater use of SDRs for international reserves, Zhou suggested that

countries should be permitted to trade in their existing reserves for SDRs at a specific exchange

rate or to turn over a portion of their reserves to be managed directly by the IMF. This is not

surprising given China‟s heavy reliance on dollar-denominated assets in the country‟s reported

$2.27 trillion dollar reserve holdings. (Poon, December 2009) Indeed, China is stuck in a “dollar

trap”: any future fall in the dollar could mean a significant capital loss for China, and yet

diversifying out of dollars could drive the value of the dollar down, triggering a capital loss.

(Krugman) Indeed, Zachary Karabell writes that “with so much invested in the U.S., China can

no more tolerate a severe U.S. implosion than Americans can. Any action taken by China to

imperil the economic stability of the U.S. would be an act of mutually-assured destruction.”

(Karabell) Thus, two possible exit strategies for China are to persuade the world to adopt SDRs

as the new super-sovereign global currency or encourage the internationalization of the yuan.6

STATE OF THE WORLD: CURRENT INTERNATIONAL SITUATION

China‟s “dollar trap” leaves the country‟s leaders in a bind: either they can diversify away from

dollar-denominated holdings and take a potential capital loss from the ensuing depreciation of

the dollar or China can maintain its dollar assets and let the market determine the dollar‟s value.

Indeed, senior Chinese officials have expressed concern about the dollar‟s value since the onset

of the current financial crisis. In November 2009, Finance Minister Xie Xuren stated that “the

nations that issue key reserve currencies should maintain the value of their currencies and

exchange-rate stability, preventing negative spillover effects.” (Poon; Xinhua) Since China

owns approximately $1 trillion in U.S. assets,7 concern that the dollar‟s declining value, in

addition to its growing fiscal deficit and loose monetary policy, will erode the value of China‟s

reserves is justified. Yet, even though China worries about its dollar exposure risk, the PBOC

has continued to purchase U.S. treasuries, albeit shifting somewhat into shorter-term treasury

bills.8 (See Chart 6) In section VI, I argue that the approach China seems to have taken to get out

of its “dollar trap” is to deliberately and incrementally regionalize the use of the RMB and begin

to diversify its reserves out of U.S. dollars.

Strong Dollar or Strong Yuan?

5 The value of the SDR is defined by a basket of currencies, including the dollar (44 percent), the euro (34

percent), the yen (11 percent), and the pound (11 percent). (See: Carbaugh and Hendrick) The weights

reflect the level of exports and imports of the four countries during the previous five years, and they are

reviewed every five years by the IMF. 6 For an interesting take on this, see Mallaby. 7 According to Pieter Bottelier, China‟s central bank and other government-owned financial institutions, including China‟s sovereign wealth fund (CIC) hold an estimated $1.5-1.6 trillion in U.S. dollar denominated financial assets. (China Brief) 8 In May, China added $38 billion in US treasuries, bringing its total holdings to over $800 billion, the

Treasury Department reported.(Kutner, 2009); See also Bradsher.


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The Chinese government has been concerned with the dollar‟s volatility since the outset of the

financial crisis. (Chart 1) When the crisis emerged, the dollar strengthened by more than 10

percent, as investors de-leveraged and shifted into safer and more liquid investments such as

U.S. treasuries. As financial markets have recovered, though, the dollar is beginning to

depreciate, falling back toward its pre-crisis level. (Boone and Johnson; Shah) Treasury

Secretary Geithner has consistently reassured international partners that the United States is

committed to a strong dollar. Yet, the appropriate value of the dollar over longer time horizons

is difficult to pinpoint: the dollar's worth is based on a complex web of shifting and interlocking

factors, including trade balances, government spending, interest rates, inflation, and economic

growth. (Gongloff, October 2009) Also, for the United States, many argue that a weaker dollar

will contribute to global rebalancing by reducing the current account deficit through increased

U.S. exports. However, the relationship between exchange rates and the trade balance is

complex. For example, the U.S. trade deficit with China increased by 33 percent between 2005

and 2008, while the dollar fell between 18 and 22 percent against the yuan. (Gongloff, November

2009) Likewise, the widening of America‟s post-Plaza Accord trade deficit with Japan is also

instructive.9

For China, after some progress was made when the PBOC un-pegged the RMB from the dollar

in 2005, allowing it to appreciate 21 percent, the central bank has kept the exchange rate at about

6.83 to the dollar since July 2008. Thus, as the dollar depreciates, so too does the yuan (in real

effective terms). The World Bank reports that China‟s nominal effective exchange rate (NEER)

depreciated 7.6 percent this year due to the informal peg to the dollar. (Chart 2) This has been

difficult for its neighbors in Asia, many of which have intervened in currency markets to stem

their own appreciation. (Roman) Since March, the dollar – and by extension the yuan – has

fallen 24.3% against the South Korean won, 10.4% against the Singapore dollar, 7.7% against

the Thai baht, and 9.3% against the Malaysian ringgit. (Frangos)

While IMF Managing Director Dominique Strauss-Kahn has recently called for China to address

its “undervalued” currency, however, not everyone at the IMF agrees with him. The IMF‟s 2009

public information note, which summarizes Article IV consultations with China, reported that

while some Directors “supported the view that the renminbi remains substantially

undervalued…a number of other Directors pointed to the methodological difficulties of making

exchange rate assessments.” That said, many economists have estimated the significant

undervaluation of the RMB. Morris Goldstein and Nicholas Lardy of the Peterson Institute for

International Economics contend that the yuan is undervalued by 15-25 percent.10

China has

9 Michael Pettis notes that, “many analysts have long pointed to exchange-rate manipulation as a quick fix for

trade imbalances, or the gap between what a country produces and what it consumes. When the Japanese and

German currencies soared in value against the dollar after the Plaza Accords of September 1985, many

analysts thought that these countries‟ trade surpluses with the U.S. would decline. They were partly right. The

German trade surplus with the U.S. declined. But even though the value of the yen doubled, Japan‟s trade

surplus surged.” 10 In his introductory chapter, Dr. Lardy asserts that “any methodology that defines the equilibrium exchange

rate for the renminbi as the real effective exchange rate that would produce „balance‟ in China‟s global current


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deflected criticism of its currency policy, preferring to focus attention on its role in global

economic recovery. However, the PBOC did change the wording in its quarterly monetary

policy reports this year, dropping the line about keeping the yuan “basically stable” and adding

that foreign exchange policy would take into account “international capital flows and changes in

major currencies.” (Economist, November 2009)

New Reserve Currencies?

The proposal for enhanced use of SDRs has not succeeded in garnering much attention apart

from an agreement by the IMF to issue SDR-denominated bonds (see: Batson, July 2009), and

many difficulties remain before SDRs can truly be transformed into a viable alternative to the

dollar. The question as to whether the U.S. dollar should remain the dominant reserve currency,

however, has continued to prompt debate. Even World Bank president Robert Zoellick

cautioned the United States against assuming that the dollar would continue unchallenged as the

international reserve currency. (Dunphy)

A reserve currency is a currency that is held in significant amounts by governments and financial

institutions as a means to pay off international debt obligations or as part of their foreign

exchange reserves.11

Factors that make specific currencies desirable for reserve holdings include

the country‟s share of world output and trade, macroeconomic and political stability, and deep

and liquid financial markets. (Wu, F.; see also Hu, F.) In 2008, the IMF reported that the U.S.

dollar comprised 64 percent of (allocated) exchange reserves.12

The euro comprised roughly 24

percent, followed by the yen and pound, each with below 5 percent of the total. (See Chart 3)

The U.S. Treasury estimated the dollar‟s share at 62.5 percent, with the euro at 27 percent.13

What is remarkable is not only the proportion, but also how consistent these shares have

remained since the euro was introduced in 1999. (Chart 4) There has been relatively no

adjustment out of the U.S. dollar over the last decade. This suggests a fair amount of inertia in

the composition choice of international reserves by central banks. Despite the relatively stable

composition, the euro and the yen – and more recently the SDR and RMB – have been touted as

potential challengers. Yet, neither currency has been able to increase their share in overall

reserves.

In terms of overall size, the euro area, which includes the European countries who use the euro

or coordinate their currencies with the euro, had a combined gross domestic product of $15

trillion dollars in 2008, or roughly equal in size to the United State. Indeed, the euro is the most

actively traded currency after the dollar and, as noted above, comprises about 26 percent of

international reserves. In 2006, the number of euro notes in circulation surpassed the number of

account position, or in its basic balance, or in its overall balance-of-payments position, yields the qualitative

conclusion that the renminbi is significantly undervalued.” (Lardy, pg. 3) 11 See: http://www.investopedia.com/terms/r/reservecurrency.asp 12 Allocated exchange reserves make up about 75 percent of total international reserves. For an explanation of the accounting methods, see: http://www.imf.org/external/np/sta/cofer/eng/index.htm 13 In fact, the Treasury estimates that demand for dollar reserves has outpaced euro reserve holdings, and that the shift in the relative weights from 1999 to 2008 reflects only the relative values of the currencies rather than a shift in preference. See: http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates/pdf/Appendix%201.pdf

http://www.investopedia.com/terms/r/reservecurrency.asp

http://www.imf.org/external/np/sta/cofer/eng/index.htm

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates/pdf/Appendix%201.pdf

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates/pdf/Appendix%201.pdf


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dollars in circulation, reflecting its growing role as a local transaction currency. (Carbaugh and

Hendrick) Finally, the European Central Bank (ECB) is credible in its commitments to target

inflation and maintain price stability.

Despite the positive attributes of the euro, several economists question the stability of the

eurozone, noting the strict limits on debt ratios and fiscal deficits. Recent editorials have even

questioned whether the euro can withstand the current economic crisis. The largest limitation to

the euro, however, is the development of deep and liquid financial markets. Europe does have

sophisticated and well-developed financial markets, however, the bond markets in Europe

remain differentiated and fragmented.14

This limits the types of assets foreign banks can hold as

reserves, and therefore makes the euro a less optimal reserve currency compared with the dollar.

Finally, the ECB itself is reluctant to share a greater role with the dollar. This Fall, the ECB

reported that the global financial crisis has had little effect on the dollar's preeminence in

international financial markets, and that the financial crisis had left the shares of major

international currencies in financial markets “broadly unaffected.” (Perry and Smith) It seems

likely, then, that the euro will maintain its share of global reserves but will not challenge the

dollar in the near-term.

Unlike the ECB, the Bank of Japan actively encouraged the international use of the yen during

the 1980s and 1990s. Following the Asian financial crisis, Japan took a number of steps to

promote the use of the yen within Asia – much as China‟s PBOC is suggesting today with the

RMB. Unfortunately Japan‟s prolonged economic stagnation and underdeveloped yen money

and capital markets have limited the internationalization of the yen.15

Thus, its share of total

reserves is unlikely to exceed its 1990s peak of 8-9 percent.

INDICATIONS OF THE RMB’S INTERNATIONALIZATION

Since Zhou‟s proposal to promote SDRs has not gained traction, another key strategy for

managing the risks associated with China‟s dollar holdings is encouraging the RMB‟s

internationalization. According to the IMF, international currencies play a role in foreign

exchange trading, trade invoicing, and financial investments. They also function as an exchange

rate anchor and as a reserve currency for governments. (Cohen, 2009) Moreover, international

currencies should meet the three standard functions of money – medium of exchange, store of

value, and unit of account.

Since the onset of the current financial crisis, Chinese officials have indicated a desire for the

RMB to become an increasingly international currency, but expanding the international use of a

currency is not synonymous with making a currency an international reserve currency. (Kroeber)

Thus, internationalization is often an incremental process in which the currency takes on the

following functions: settlement currency, vehicle currency for third-party trade or foreign

14 Brendan Kelly writes, “By most accounts, the liquidity and sophistication of euro financial markets are also fast approaching those of U.S. dollar markets. However, euro bond markets remain segmented between its 16 member countries, with varying credit worthiness and thus pricing.” (Kelly, pg. 12) 15 According to Kelly, the key structural obstacles for the yen‟s adoption as a reserve currency are the inferior liquidity of the yen money market in relation to the U.S. dollar, primarily due to transaction taxes and the undersupply of government treasury bills. (Kelly, pg. 12)


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exchange transactions, unit of account, and finally reserve currency. (Chinn, see also: Kelly,

Brandon) While challenges to the RMB‟s use as a reserve currency remain, it is possible to

evaluate indications of the RMB‟s process of internationalization.

RMB AS A SETTLEMENT CURRENCY

The primary indicator of the RMB‟s increasing use internationally is its role as a settlement

currency for international trade, particularly in Asian regional trade. The Chinese government

has adopted two policies to drive the international use of the RMB for trade: first, a pilot RMB

settlement program; and second, a series of currency swap agreements with counterpart

countries. Clearly, one purpose of these trade settlement programs is to limit the increase in U.S.

dollars entering China through the trade account.

RMB Settlement Scheme

Over the past year, the Chinese government has developed a series of RMB trade settlement

schemes between cities and firms in the mainland with trade partners in Hong Kong, Macau, and

Southeast Asia. The PBOC has also signed agreements with neighboring countries including

Vietnam, Myanmar, Russia, and Mongolia to allow settlement of the bilateral trade account in

their domestic currency or RMB. (Xinhua, March 2009) On his recent visit to China, President

Luiz Inácio Lula da Silva announced that Brazil and China had agreed to settle trade deals in

their respective currencies.

In December 2008, China announced pilot programs to settle trade deals in RMB at the firm

level between Guangdong province and the Yangtze River Delta and the two Special

Administrative Regions of Hong Kong and Macau. In addition, a similar arrangement was

outlined for exporters in Guangxi Zhuang Autonomous Region and Yunnan Province to settle

trade in RMB with their ASEAN trade partners. (China Daily, November 2009) In his

government work report in March 2009, Premier Wen Jiabao confirmed the trial operation of

settling trade in RMB with Hong Kong and Macao. (China Daily, March 2009) Moreover,

during the March 2009 meeting of the Chinese People‟s Political Consultative Conference

(CPPCC), Vice Governor of the PBOC Su Ning reported that the PBOC would reduce

“institutional obstacles for cross-border trade settlement in the yuan.” (China Daily, March 2009)

Furthermore, in April, China announced another pilot program to settle cross border trade in

RMB in five cities, including Shanghai, Guangzhou, Shenzhen, Zhuhai, and Dongguan. (See

also: Wu, Friedrich) These settlement trails allow a small number of export firms – the number

was limited to 400 in September 2009 – to settle with trade partners in yuan. (Batson, September

2009) What is not surprising is that these five cities represent China‟s exporting powerhouses

and are the key drivers of much of China‟s economic growth. Also, Shanghai and Guangdong

province are politically important regions for China‟s leadership.

The RMB settlement program will benefit export companies in China by reducing the exchange

rate risk due to fluctuations in the value of the dollar, which is the currency used to quote prices

for most imports and exports. Moreover, as many of China‟s imports from Southeast Asia, Hong


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Kong, and Macau are intermediate goods, trade settlement in RMB will help to stabilize the

production costs of final goods being processed or assembled on the mainland.

One precedent for China‟s trade settlement program comes from Japan‟s experience

internationalizing the use of the yen. (Batson, September 2009) Andrew Batson notes that

Japanese companies were successful in convincing trading partners to do business in the yen

rather than the dollar, but that the use of yen in trade was limited. Indeed, the share of Japan‟s

exports settled in yen has ranged from 35 to 40 percent for the past twenty years, whereas

imports settled in yen account for only 20 to 25 percent of total imports. (Batson, September

2009) Japan‟s experience may prove instructive for China, and suggests that trade settlement in

the RMB will only play a marginal role in the internationalization process. Still, some scholars

assert that “increased use of the RMB as international settlement currency should make it easier

for China to flexibilize its exchange rate management and thus reduce the need for large-scale

domestic sterilization of excess liquidity in domestic banks. It should also facilitate accelerated

opening of China‟s capital account and movement towards full convertibility of the

RMB.” (Bottelier, April 2009)

While the RMB trade settlement policy is an important first step in internationalizing the use of

the RMB, it is not yet clear whether the policy has been successful. First, technical issues

remain. In March, Zhou Xiaochuan stated that the PBOC would issue a policy statement for

facilitating yuan settlement because there were still obstacles related to the transaction systems

of banks and regulating policies. According to one report, there are two ways for commercial

banks to provide yuan-based settlement services. A Chinese bank can either entrust a foreign

bank to be its agent bank or deputize its overseas branch to offer RMB account-based services.

(Lan, April 2009) In November, the Bank of China (Hong Kong) announced that it had signed

the Agreements for Clearing and Settlement of Renminbi (RMB) Trade Settlement with

commercial banks in Southeast Asia, including Bank of China Bangkok Branch, Bank of China

Manila Branch, Bank of China Jakarta Branch, Bank of China Singapore Branch, and Bank of

China (Malaysia) Berhad. (Xinhua, November 24, 2009) Therefore, in addition to providing a

wide range of RMB services such as deposits, foreign exchanges, remittances, bonds, and trade

finance for corporate clients, signatory banks will be able to participate in the RMB Interbank

Money Market in Hong Kong and provide other RMB businesses as approved by the regulatory

authorities. (Xinhua, November 24, 2009)

Unfortunately, it is still not clear how much RMB settlement is, in fact, occurring at this point.

According to the PBOC, from July to mid-September, total trade value settled in RMB under the

pilot scheme amounted to only 70 million yuan. (Ng) Since the RMB is not freely convertible on

the capital account, settlement remains difficult. This is because foreign counterparties may not

have access to RMB to pay for goods imported from China. Also, banks continue to convert

payments into dollars, euros, or other convertible currencies. (Lan, May 2008) Finally, because

the pilot program is voluntary, firms decide whether or not they want to participate. According

to reports, many firms outside of China do not want to quote prices or receive payment in RMB

because there is no forward market for the yuan, making it difficult for firms to hedge risk.

(Economist, July 2009)


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Though there is disagreement with this assessment, HSBC economist Qu Hongbin predicts that

by 2012 over 40% of China's total trade could be settled in yuan. (Economist, July 2009)

Despite complications in the program thus far, the direction is clear, and once the appropriate

mechanisms are in place, there should be an increase in companies using this as a settlement

option.

Currency Swap Agreements

In addition to the RMB trade settlement program, China has also announced currency swap

agreements with countries as wide-ranging as Argentina, Belarus, Hong Kong, Indonesia,

Malaysia, and South Korea. (McNally) Since December, the PBOC has signed a total of $95

billion dollars (650 billion yuan) worth of currency-swap agreements. (See Chart 5; Peaple;

Hsiao) In addition to mitigating exchange-rate risks arising from trade settlement in the dollar,

these currency swaps are intended to provide much-needed liquidity to foreign central banks.

This is particularly important for the Hong Kong Monetary Authority, as the PBOC can adjust

the liquidity ceiling to provide additional RMB liquidity when needed. (Ng) For the other

countries, the currency swaps inject RMB into the financial system, and local firms importing

Chinese goods can pay for them with yuan borrowed from domestic banks rather than dollars.

Indeed, since the yuan is not freely convertible, there is little other use for it than for trade

transactions. (Peaple)

The swaps with Korea, Malaysia, and Indonesia also reflect the growing influence of regional

monetary policy coordination and the continuing development of the Chiang Mai Initiative

(CMI). The CMI was established in 2000 to encourage bilateral swap agreements between the

ten members of the Association of Southeast Asian nations plus China, Japan, and South Korea

(or ASEAN+3).16

In the wake of the Asian financial crisis, the CMI was viewed as a method to

enhance self-help and support mechanisms in East Asia, as well as lay the groundwork for

enhanced financial cooperation and reform of international financial institutions. (Henning, pg.

2) Indeed, at that time, Japan proposed the development of an Asian Monetary Fund (AMF) to

rival the IMF and provide financial sector support in Asia during future crises. (Hyong-Kyu, pg.

457) The proposal did not succeed, but the CMI has continued to mature.17

In 2005, the

ASEAN+3 finance ministers launched the second stage of the CMI, doubling the nominal size of

the swaps to $83 billion.18

The following year, the ASEAN+3 countries began to work on

multilateralization of the CMI, and have reached agreement on many of the key elements,

including “the total size ($120 billion), the form of funding (self-managed reserve pooling), the

legal modality (legally binding single contractual agreement), and the proportion of contribution

16 In December 1997, the Association of Southeast Asian Nations (ASEAN) and three northeast Asian countries—Japan, China, and South Korea— established the ASEAN+3, a forum for coordinating cooperation among the participant countries, which they institutionalized in 1999. (See Hyong-kyu) 17 For example, China first signed a $2 billion currency swap agreement with South Korea in June 2002; the

two countries increased the swap amount to $4 billion when they extended the agreement in 2005. A new

agreement, signed in December 2008, further increases the amount to $26 billion (180 billion yuan) and

allows for direct exchanges between the yuan and Korean won. (Shi Yongming) 18 According to Henning, eliminating double-counting and removing arrangements that have mostly symbolic

value reduces the total swap amount to $50 billion to $60 billion. See: Henning, pg. 2.


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between ASEAN and the three Northeast Asian countries (20:80).” (Hyoung-Kyu, pg. 452; see

also Henning, pg. 4)

Despite being considered outside of the CMI framework,19

the recent swap agreements illustrate

the significant amplification of the bilateral coordination in the wake of the current financial

crisis. Indeed, I will argue in the following sections that the lessons of the Asian financial crisis

played a role in the current economic crisis, and strengthened bilateral financial ties between the

ASEAN+3 countries. Also, as in the RMB trade settlement program, China‟s currency swaps

aim to increase international circulation of the yuan in Asia. In developing the CMI and

proposing the AMF, Japan sought to facilitate the internationalization of the yen by encouraging

neighboring countries to use the yen for more transactions.20

Clearly this is a policy goal of the

Chinese government as well.

RMB AS A STORE OF VALUE

Since the yuan is not fully convertible on the capital account, the market for yuan-denominated

assets is limited. To address this problem, the Chinese government has been actively promoting

the yuan bond market in Hong Kong. Prior to this year, the sale of yuan-denominated bonds was

limited to Chinese banks, along with multilateral banks, including the Asian Development Bank

and International Finance Corporation. Also, bonds were only sold within China. (LeVine) In

September 2009, China issued 6 billion yuan ($880 million) of sovereign bonds (often referred to

as Panda Bonds). While state-owned banks had already sold nearly 22 billion yuan ($3.2 billion)

of bonds in Hong Kong since 2007, HSBC and the Bank of East Asia became the first foreign

banks to raise yuan in Hong Kong. (LeVine; Bloomberg)

In this sense, Hong Kong is poised to serve as a key financial intermediary for the RMB‟s

expanded use abroad. Indeed, Hong Kong has benefited from the one country, two systems

policy, which has allowed it to manage its financial system with few interventions by the

Chinese government. Since 2004, reforms were instituted to begin the process of integrating the

two financial systems. On February 25, 2004, the PBOC began to allow Hong Kong banks to

open individual deposit, exchange, remittance, and bankcard services. This was followed by

RMB business in Macau at the end of 2004. In January 2007, the central bank allowed mainland

financial institutions to issue yuan-denominated financial bonds in Hong Kong. (Beijing Review,

March 13, 2008) And, integration has intensified during the crisis: reports for 2008 indicate that

19 “Recently, East Asian central banks have announced several new swap agreements outside the ambit of the

CMI. In December 2008 the three countries in Northeast Asia announced (a) an increase in the size of one of

the Japan-Korea swaps from the equivalent of $3 billion to the equivalent of $20 billion and (b) the

establishment of a new China-Korea swap equivalent to roughly $26 billion. In concluding these agreements,

Japanese and Chinese officials appeared to be responding to the extension of a $30 billion swap agreement to

Korea by the US Federal Reserve. China subsequently also extended two local-currency swap arrangements,

one to Hong Kong equivalent to about $34 billion and the other to Malaysia equivalent to about $13.5

billion.” (Henning, pgs. 2-3) 20 According to Hyoung-kyu, Japan‟s BSA with China is denominated on Japan‟s side not in dollars but in

yen, marking the first time the yen has been used as the key currency in such an agreement. (Hyoung-kyu

Chey, pg 461)


12

yuan deposits in Hong Kong increased 86 percent to 56.1 billion yuan ($8.2 billion). (McMahon)

According to the China Daily, Hong Kong will operate as a parallel yuan market rather than just

serving as an overseas yuan settlement hub. To make this system work, there must be an

adequate yuan-asset market in the city to provide “sufficient investment outlets for yuan holders

on the one hand and financing channels for overseas importers on the other.” (Ng) The first step

for this is the expansion of yuan-denominated bonds; the next step may be to allow the trading of

locally-listed shares in yuan.

The September bond issue of 6 billion yuan in government debt is relatively small compared to

Beijing's overall outstanding government debt of 6.3 trillion yuan. It is also quite small relative

to the United States Treasury market of nearly $7.5 trillion dollars (51 trillion yuan). (McNally)

Nonetheless, the increased international use of the RMB as a transaction and international

settlement currency will also promote it as a store of value, even before full convertibility on the

capital account. (Bottelier, April 2009) Moreover, by creating an offshore market for yuan

financial instruments that foreign central banks and investors can trust, the RMB will become

more attractive for investors for financial diversification. Chinese government bonds issued

overseas and perhaps bonds issued by Chinese state firms and banks with quasi-sovereign

guarantees could provide the pricing benchmarks, liquidity, and security that an internationalized

market for yuan needs to develop. (McNally)

In addition, the yuan bond market also mitigates the exchange rate risk of China‟s dollar-

denominated reserves. In an article in the influential business magazine, Caijing, Yu Yongding,

a public intellectual and economist with the Chinese Academy of Social Sciences, proposes the

benefit of Panda bonds, namely reduction in U.S. dollar-denominated reserve assets through the

sale of these assets to private banks. Using the example of the Asian Development Bank (ADB),

he writes, “the ADB can issue 10-year Panda bonds in the Chinese interbank bond market, using

proceeds to purchase U.S. dollars from China‟s central bank. In the end, ADB would receive a

sum of liquid dollar funds and pressure on China‟s central bank due to mounting dollar reserves

would be reduced.” (Yu) In his view, Panda bonds are a critical tool for diversifying the

PBOC‟s dollar holdings without driving down the value of the dollar on the foreign exchange

market. It is not yet clear whether this is, in fact, what has happened after the September 2009

bond issuance.

While the expansion of yuan-denominated bonds may signal a move to liberalize the sale of

additional financial assets and increase the yuan‟s international use, there are still considerable

challenges in terms of overall capital market development. Despite liberalization of the current

account in the mid-1990s, which makes the yuan convertible for trade transactions and

conditionally for foreign direct investment (FDI), the yuan is not convertible for the majority of

portfolio capital transactions.21

Thus, China has lower equity and bond market capitalizations to

GDP ratios relative to the issuing countries of the other major global currencies. According to

Deutsche Bank Research, China's equity and bond market capitalizations only make up 5.9% and

21 China achieved convertibility for the RMB under the current account in December 1996. However, the

original policy goal of achieving capital account convertibility by 2000 has been quietly abandoned, in part

due to the intellectual backlash against the idea of free capital mobility in the aftermath of the Asian Crisis in

1997-98. (See Fred Hu, Cato Journal)


13

2.4% of the world‟s equity and bond markets, respectively. (Wu, F.) Moreover, a web of

regulatory barriers restricts access to China‟s capital markets. Business Week reports that in

terms of inward portfolio investments to China, the average amount between 2003 and 2007

represented less than one percent of total portfolio investments globally. (Wu, F.)

The Chinese government has begun to experiment with greater liberalization, but these reforms

are incremental and slow so as to not overburden a still fragile banking and financial system.

One development was the introduction of Qualified Foreign Institutional Investor and Qualified

Domestic Institutional Investor (QFII and QDII) programs to allow two-way cross-border

portfolio investment flows. Additionally, there may be further reform next year: according to

Guo Shuqing, former head of the State Administration of Foreign Exchange, the yuan will be

made convertible by 2010 for about 70 percent of the 43 capital transaction items under the IMF

classification. (Wu, F.) If the reduction in restrictions on capital transactions facilitates

investment in yuan-denominated assets by foreign investors and central banks, then China will

greatly enhance the internationalization prospects of the RMB.

RMB AS A UNIT OF ACCOUNT

A third indication of the RMB‟s international use is the extent to which the yuan serves as a unit

of account. Often this is conceived of in terms of using a currency for commodity pricing.

Indeed, in Zhou Xiaochuan‟s proposal, one of the main recommendations was to use the SDR

rather than the dollar to price commodities. While pricing in SDRs is unlikely in the near future,

pricing commodities in RMB or with a basket of currencies including the RMB could become

more popular. Earlier this year, there were reports that oil producing countries in the Middle

East were in secret talks with France, Russia, China, and Japan to replace the dollar in oil trading

with a basket of currencies. (Davis and Curran; Roman) Although the talks turned out to be

fabricated, the question of whether the dollar will remain the currency in which oil and other

primary commodities are priced is extremely relevant given the dollar‟s recent volatility.

McKinnon‟s hypothesis, named for economist R.I. McKinnon, states that specialized

manufactured products tend to be invoiced in the exporter‟s currency, while undifferentiated

primary products tend to be invoiced in a major international currency. (Kelly, pg. 8) Therefore,

given China‟s huge demand for primary commodities from oil to timber to precious metals, it

stands to reason that China could begin to assert its leverage on pricing of these commodities.

Indeed, by 2005, China had become the world‟s leading consumer of most major metals as well

as agricultural products. (Kelly, pg. 9) Up to now, pricing commodities in RMB has not yet

happened; however, this area presents an opportunity for China to advance the use of its currency

for specific commodity trade transactions.

Another recent development has been the pricing of new sales contracts in RMB. COSCO Corp.

(Singapore) Ltd., a Singapore-listed Chinese shipbuilding company, reported that it would quote

sales contracts in RMB. This is the first time a large Chinese company has officially announced

a policy of quoting in RMB rather than in dollars. The company‟s president Ji Haisheng stated

that quoting in RMB would help to mitigate the risks of a volatile dollar. (Lan, May 2008)

Beijing Review also reported that Yiwu Jindelai Plastics Packaging Co. Ltd. (YJPP) in Zhejiang


14

Province would quote export contracts in RMB as well. Again, it is too early to know whether

this will become a trend, but it may signal growing confidence in the RMB.

RMB “REGIONALIZATION”

What is clear in analyzing China‟s policies to internationalize the RMB is that the primary focus

in the short-term is encouraging the RMB in regional trade and financial transactions. This is

supported by a recent statement by Xia Bin, the president of the Financial Research Institute of

the Development Research Center of the State Council, who commented that “China is not

pursuing the optimum target of complete internationalization of the RMB, but a suboptimal one:

gradual regionalization of the currency.” (Hsiao)

As with the Japanese yen, the RMB‟s promotion in Asia is quite logical. In terms of trade

volume, ASEAN and northeast Asia are vital trading partners for China. According to the Asian

Development Bank, of the top ten source countries for China's imports, six are located in Asia:

Japan, Korea, Malaysia, Singapore, Thailand, and the Philippines. As well, of the top ten

destination countries for China's exports, four are located in Asia: Hong Kong, Japan, Korea,

and Signapore. (See Chart 7) Moreover, the yuan is expected to play a larger role in regional

trade when the China-ASEAN Free Trade Area (CAFTA) becomes effective in January 2010.

According to Xu Ningning, executive secretary general of the China-ASEAN Business Council,

“CAFTA, which boasts the largest population among all the world's FTAs and allows zero tariff

on 90 percent of products traded between China and ASEAN, will quicken the process of

renminbi regionalization." (China Daily, November 23, 2009)

Zhang Yuyan, an academic at the Chinese Academy of Social Sciences, noted that “a favorable

balance of trade with China is a prerequisite for surrounding nations to use the RMB as a reserve

currency.” (Hsiao, Russell) Due to China‟s rapid growth over the last decade, it has replaced the

United States as the main export market for Asian countries. Data from China's General

Administration of Customs showed trade between China and ASEAN has grown over the last

decade to a high of $231.07 billion dollars in 2008. This year, ASEAN overtook Japan to

become China‟s fourth largest importer.22

For Malaysia and Indonesia, the expanded use of the

RMB for trade settlement may significantly reduce the transaction costs for trade. Indeed, this

would be important as China is Malaysia‟s fourth largest import and export partner, and

Indonesia ranks China as their fourth largest export destination and their second largest import

source. South Korea is another key trading partner with China. China is South Korea‟s largest

trade partner and South Korea is China‟s sixth largest partner. Therefore, Chinese policy to

expand the RMB‟s use as a trade settlement currency, as well as the bilateral swap agreement

with South Korea, will “improve short-term liquidity conditions in their financial systems,

promote bilateral trade and advance their economic development.” (Shi Yongming).

Expanding the RMB‟s use in Asia also helps to mitigate the exchange rate risk of the U.S. dollar.

Thailand‟s deputy minister recently stated that because the yuan was a very stable currency,

expanding its use could help reduce risks faced by ASEAN countries in using the dollar in trade

with China. (China Daily, November 23, 2009) As noted earlier, the dollar‟s value has been

quite volatile as a result of the global financial crisis. There are challenges, however, to

22 See: http://www.chinadaily.com.cn/bizchina/2009-12/08/content_9142125.htm

http://www.chinadaily.com.cn/bizchina/2009-12/08/content_9142125.htm


15

promoting greater use of yuan in ASEAN countries. For the most part, RMB settlement is

mainly adopted in border trade, which accounted for only 10 percent of China-ASEAN bilateral

trade. (China Daily, November 23, 2009) That said, if the RMB grows in acceptance within the

region, and begins to circulate in a larger area, it will develop a network effect which will

enhance its internationalization beyond the region. (Zhang, R., pg. 52)

In addition to challenges noted above, the greatest obstacle for RMB internationalization is the

lack of convertibility on the capital account. In March, Wu Xiaoling, deputy director of the

Financial and Economic Affairs Committee of the National People‟s Congress, conceded that

“whether a currency could be internationalized depends on its convertibility and the country's

national economic strength. So there is still a way to go for renminbi's internationalization.”

(Xinhua, March 2008) For China to move from trade settlement currency or regional currency to

a truly international reserve currency, it will need to open its capital account to allow foreigners

to invest freely in onshore yuan financial assets, as well as freely repatriate both earnings and

capital. (See: Kroeber)

Yet, assuming that China does succeed in making the RMB fully convertible, achieving RMB

internationalization presents certain dilemmas for the Chinese leadership. First, the loss of direct

oversight and control over the financial system – particularly credit allocation decisions – will be

difficult. Indeed, some argue that Chinese leaders prefer the ambiguity of the current financial

system since it allows them to intervene with administrative commands when needed. (McNally)

Second, the Chinese government is concerned about subjecting the still-fragile financial system

to large capital flows both in and out of the country. The advantages, however, very well may

outweigh these costs.

ASIAN FINANCIAL CRISIS AND CURRENT ECONOMIC CRISIS: LESSONS

LEARNED?

In this section, I argue that the lessons from the Asian financial crisis have reemerged in the

wake of the current economic crisis, and China is once again evaluating its macroeconomic

reforms. Looking at both the Asian financial crisis and the current economic crisis, I have

identified the following three basic “crisis lessons” China has learned: liberalizing the capital

account is risky, financial regulation is critical, and stability is preferred over volatility

(especially with regard to exchange rates). During the Asian financial crisis, the Washington

Consensus – expanding the role of market forces, reducing the role of the state in the economy,

promoting transparency through rule of law, and assuring free trade and free movement of

capital – was the dominant paradigm. (See Hellmann, pg. 835) We may find, however, that new

ideas, inconsistent with this paradigm, are developing out of the current economic crisis.

Capital Account Liberalization

One of the lessons of the Asian financial crisis was that rapid liberalization of the capital account

could trigger excessive capital flows both into and out of a country. In this view, developing

Asia suffered as a result of IMF policies to liberalize capital accounts before critical banking and

financial sector reforms were completed. Clearly, in retrospect, many economists have argued

that the policies of the IMF and World Bank were incorrect or at least inopportune. Joseph


16

Stiglitz writes that “it has become increasingly clear that financial and capital market

liberalization – done hurriedly, without first putting into place an effective regulatory framework

– was at the core of the [Asian financial crisis].” (Stiglitz) Moreover, Chinese officials have

drawn a similar lesson from the current crisis: speculative capital flows are destabilizing. In the

case of the United States and Europe, risky financial investments (and poorly understood

financial products) played a significant role in undermining global financial markets. Therefore,

in my view, China will remain quite cautious with regard to capital account liberalization in the

near term. Yet, just as following the Asian financial crisis, the Chinese government will push

through much needed reforms, albeit on an incremental level.

Following the Asian financial crisis, China initiated extensive reforms of its own banking

system. This was largely because the Asian experience demonstrated that, “…financial system

reform is the most sensitive and difficult part of the whole process of system change; if mistakes

are made in this area, with its deep roots in the everyday lives of the whole population, they

threaten the whole socio-political fabric.” (Nolan, pg. 49) According to Nick Lardy, the Chinese

government undertook the following reforms: large-scale public recapitalization of the state-

owned commercial banks; implementation of tougher asset classification and provisioning

guidelines; creation of the China Bank Regulatory Commission; reductions in the number of

bank branches and bank employees; stock exchange listing of four state-owned commercial

banks; and, sale of bank shares to strategic foreign partners. (Lardy, pg. 12) Yet, the government

maintained tight controls over financial flows in the capital account, despite liberalizing the

current account in 1996. These controls promote inward foreign direct investment and

discourage other forms of inflows, especially portfolio debt. (Prasad, pg. 86) Capital controls

also shield the domestic banking system from competition by restricting the entry of foreign

banks and by making it difficult to repatriate capital. Eswar Prasad asserts that “China‟s

approach to exchange rate policy and capital account liberalization may indicate a desire to

maintain stability on the domestic and external front, and the large stock of foreign exchange

reserves resulting from these policies may insure against vulnerabilities arising from a weak

banking system.” (Prasad, pg. 86)

Whether the PBOC and State Council feel that China‟s banking and financial systems are strong

(or healthy) enough to survive capital account liberalization is not clear. Even scholars disagree,

with some arguing that “opening the capital account to inflows and outflows could also be an

important catalyst to developing the domestic financial sector,” (See Prasad, pg. 89) while others

claim that the appropriate sequencing is to start with banking reform and finally liberalize the

capital account. (See Lardy, pg. 15) Either way, the current financial crisis will likely delay the

process of liberalization as banks focus on stimulating economic growth through investment

activity. Still, the push to internationalize (or regionalize) the RMB may be the first step in a

longer-term process of liberalization. Indeed, prior to the financial crisis, the Chinese

government did not appear to have a policy on the convertibility of the RMB, and yet now it

must consider that prospect much more seriously.23

Financial Regulation

23 See Bottelier


17

A second “crisis lesson” is the need for more effective financial regulation, particularly in

developed markets. Chinese officials have called for greater regulation and discipline in the

United States and Europe. A number of prominent Chinese officials and public intellectuals

have also suggested that the cause of the current financial crisis was not a savings glut as

proposed by Federal Reserve Chairman Bernanke but rather fiscal irresponsibility and ineffective

regulatory oversight in the United States. Indeed, China‟s official media has framed the current

financial crisis as “…the result of developed countries‟ lax financial regulation, excessive

consumption and their lasting monopoly on the international financial system.” (Xinhua)

Moreover, at the joint IMF-World Bank meetings this year, Yi Gang, director of the State

Administration for Foreign Exchange, criticized the failure of international financial institutions

when he proclaimed that “the failure of major international financial institutions to issue timely

early warnings highlights the consequences of its misfocused (sic) surveillance. Only through the

acceleration of fundamental reforms will the major international financial institutions be able to

discharge the mandate assigned to it by its member countries.”(Yi)

Thus, in the wake of the financial crisis, Chinese officials have proposed needed reforms to the

international financial architecture. One key element is for China to play a larger role. In fact,

during the Chinese People‟s Political Consultative Conference (CPPCC) in March, a Hong Kong

delegate asserted that China “must play an active role in the reconstruction of the international

financial order.” (China Daily, March 2009) Yi Gang also remarked to the IMF-World Bank

meeting that, “the persistently misaligned quota shares and underrepresentation of emerging

market and developing countries hamper Fund governance and even-handed surveillance. It

undermines Fund legitimacy and effectiveness.” Throughout the crisis, China‟s official

statements have focused on the need to include China – and emerging markets – more fully in

the international financial system. As well, its support for the G20 forum over smaller

gatherings (G8 or G2) has opened the discussion of global finance and oversight to a much

broader group of countries. China‟s official media reported that “as emerging markets have

substantially increased their weight in the global economy, especially after the subprime crisis

exploded, the G7 cannot effectively address international economic issues, and its replacement

by the G20 conforms with the tide of history.” (Love)

Beyond indicating a desire to have a larger voice in the international financial system, China has

also questioned the appropriate role of government intervention in the market. In my opinion, a

key lesson China has drawn from the crisis is a reinforcement of the critical role government

should play in the market. This is a challenge to the neoclassical economic orthodoxy of Adam

Smith‟s invisible hand and the primacy of markets. The Chinese response to the current crisis

reflects its view that government should play a more important role in supervising, regulating,

and even directing the market. Indeed, its rapid recovery in the wake of the crisis as other

countries lag behind may lend some support to China‟s view.

Stability

The final “crisis lesson” is the value of stability, particularly with respect to exchange rates. In

the literature on the Asian financial crisis, China is lauded for maintaining its tight peg with the

dollar and not devaluing the RMB. The stability of the yuan is credited for helping with Asian


18

recovery. In the current financial crisis, China has kept the yuan stable against the dollar by re-

pegging the RMB in July 2008.

Stability is also related to capital account liberalization. The Chinese government is justified in

worrying that liberalization of the capital account may cause instability in the banking and

financial system. As Joseph Stiglitz writes, “capital market liberalization is systemically

associated with greater instability, and for good reason: capital flows are markedly pro-cyclical,

exacerbating economic fluctuations, when they do not actually cause them.” Stiglitz also argues

that there is increasing volatility following liberalization, particularly with short-term capital

flows, and therefore, an appropriate regulatory framework is a necessary precondition.

Moreover, there is mounting evidence that capital account liberalization heightens the risk of

currency crisis – one reason why Asian central banks have been so active in amassing foreign

exchange reserves following the Asian financial crisis. Barry Eichengreen suggests a variety of

policy responses for central banks to operate in the „messy middle,‟ or between complete

convertibility and strict capital controls. Eichengreen also advocates liberalizing financial

markets prior to opening the capital account. He notes that “liberalization of the capital account

thus should not precede recapitalization of the banking sector, significant strengthening of

prudential supervision and regulation, and the removal of blanket guarantees.” (Eichengreen)

This is clearly the strategy that the Chinese have adopted.

A final thought on stability: China‟s policy to maintain an undervalued currency and promote

the export sector also relates to concerns about social stability. Job creation is critical to the

Chinese Communist Party, and the export sector has served as a key driver of employment

growth, particularly for unskilled workers who migrate from central and western China to work

in labor-intensive industries in coastal areas. According to one scholar, “…the Chinese

leadership sees maintaining employment – particularly in the urban centers along the coast,

where much of the development of the foreign invested manufacturing sector has occurred – as a

„prerequisite for maintaining social stability, and perhaps even its grip on power.‟” (Kaplan, pg.

1192) Should the export sector lose its competitive advantage, its employment generation

capacity will also be jeopardized. Without alternatives in place in the service sector or other

industries, China‟s government may face a crisis of legitimacy – as its legitimacy in the post-

reform era has hinged on steady economic growth. Indeed, the relationship of political

instability with financial crisis is long-standing: Marx noted that “since the commencement of

the eighteenth century there has been no serious revolution in Europe which has not been

preceded by a commercial and financial crisis.” (Nolan, 2005, pg. 8)

CHINA’S STRATEGY: REGIONAL INCREMENTAL INTERNATIONALIZATION

(RII)

These three “crisis lessons” have contributed to what I argue is China‟s strategy of regional

incremental internationalization (RII). The Chinese government‟s policy to gradually promote

the international use of the yuan should come as no surprise to anyone who has studied China‟s

reform path. From the outset of economic reforms in 1978, Deng Xiaoping and his successors


19

have followed a careful path of “groping for stones to cross the river.”24

Before each reform is

initiated on a national level, experimental pilot programs are developed. Just as with the RMB

internationalization scheme, pilot reforms are most often initiated in Shanghai and Guangdong

province. Pilot programs are important as they enable the government to modify policies on a

small scale if problems arise, and flexibly adjust the pilot rather than the full-scale program. As

Harry Harding noted, “potential reform programs are adopted and implemented in selected

sectors, regions, or enterprises in order to judge their effectiveness and feasibility. Those that

succeed can then be adopted on a wider basis, while those that fail can be abandoned or

modified, without inflicting much damage on the overall reform effort.” (Harding, pg. 87) Deng

Xiaoping, himself, argued that China was engaged in an experiment of reform. He said, “for us,

it [reform] is something new, and we have to grope around to find our way…Our method is to

sum up experience from time to time and correct mistakes whenever they are discovered, so that

small errors will not grow into big ones.” (Harding, pg. 87)

Thus, in economic reform, the principle has been consistent experimentation before widespread

adoption of a particular policy. (Nolan, 2004, pg. 3) This approach is evident in the RII of the

RMB as well. Each step – from currency swap agreements with trade partners to the expansion

of yuan-denominated assets –begins to ease the CCP‟s macroeconomic control, but only within

strict parameters. Of course, expanding the RMB‟s use abroad and making it a more viable

international currency will result in pressure to revalue the yuan‟s exchange rate and loosen the

remaining capital controls. For now, though, the Chinese government remains cautious. In

March, Yi Gang told the official Chinese media that while it was possible that the global

financial crisis would facilitate the process of making the yuan internationally accepted, there

was no need to push for that (emphasis added). Therefore, it is likely that China will continue to

grope for stones to cross the river, encouraging reform of the international system – and the

RMB‟s role in it – on an incremental basis.

IMPLICATIONS AND CONCLUSIONS

China‟s approach – regional incremental internationalization –reflects the Chinese government‟s

continued hesitancy for widespread and rapid reforms. Indeed, the lessons from past economic

crises warn against pushing the RMB too far, too fast. Therefore, I do not anticipate either a

major shift in China‟s RMB exchange rate policy in the near-term, nor complete liberalization of

the capital account in the next few years. Instead, I believe that Chinese officials will muddle

through, or grope for stones to cross the river, managing China‟s economic recovery before

considering any changes to the present exchange rate policy.

Over time, China‟s approach to RMB internationalization should allow for incremental

substitution away from dollar-denominated reserve assets, thus digging China out of its “dollar

trap.” As Yu Yongding suggested, the sale of panda bonds to foreign financial institutions could

help the PBOC decrease its dollar reserves. Also, expanding the RMB regionally through

currency swaps and trade settlement programs will enhance its acceptance in Asia and create

network effects. If successful, it will also reduce somewhat the increase in U.S. dollars accruing

on the trade account. The pilot programs described in section III will also reduce transaction

24The Chinese idiom is the following: 摸着石头过河


20

costs related to trade and finance in Asia, which is a win-win for China and its regional trading

partners. Finally, the RII approach will improve the banking sector‟s performance by allowing

banks to profit from increased transactions and intermediary business as well as the creation of

RMB derivatives without intense competition from foreign competitors. In other words, China

can promote banking and financial sector reform – to develop deep and liquid RMB markets –

before fully opening the capital account and allowing foreign competition in the domestic

market.

China‟s policy of incremental regionalization also reduces global exchange rate risk because it

will not test the international system while it is still emerging from the crisis. Were China to

liberalize its capital account and aggressively push for RMB internationalization, global markets

would respond in unpredictable ways. Beyond the impact this would have on the dollar,

speculative flows of hot money into China, as well as the political and economic effects of a

large RMB appreciation, would likely prove destabilizing for the PBOC and Chinese

government. On the downside, the incremental nature of China‟s policy means that it will take

considerable time before real progress is achieved. This lag between slight regionalization and

true internationalization of the RMB (and corresponding exchange rate appreciation) exposes

China to the risks of a potential dollar collapse. It also heightens inflationary pressures –

particularly in foodstuffs and oil – as China‟s monetary policy relies on blunt administrative

measures rather than more sophisticated tools such as interest rate adjustments. Incremental

reform of China‟s exchange rate system will also seriously limit global rebalancing efforts.

Conclusions

Since Zhou Xiaochuan first proposed an overhaul of the international economic system and

replacement of the dollar as the de facto international reserve currency, the majority of

commentators have focused on whether the yuan could, in fact, challenge the dollar. In my view,

this is premature. First, the consistency in the composition of international reserves over the last

decade suggests extraordinary inertia, as well as considerable network and liquidity advantages

for the U.S. dollar. Second, the experience of the euro and yen demonstrate the critical

importance of deep and liquid financial markets. At this point, China has a long way to go

before its financial markets are considered deep and liquid. Finally, China has not liberalized its

capital markets, thus restricting the convertibility of the yuan. Therefore, I believe that while the

ascent of the RMB will occur over time, it will be a very long time before the RMB truly rivals

the dollar.

In my opinion, what should be the focus of attention is the willingness – indeed eagerness – of

China‟s leaders to share responsibility for the international financial system. If China wants to

become a key player in international finance, then the United States should welcome its

expanded role. In fact, just as joining the World Trade Organization exposed China‟s trade

policies to international appraisal, so too would China‟s expanded role in the IMF and other

financial institutions expose its monetary policies to international review. In the end, RMB

internationalization and China‟s stepping out in international finance are good for the U.S. dollar

and the American economy. They should, therefore, be encouraged by U.S. policymakers.


21

Chart 1: Volatility of U.S. Dollar during Financial Crisis (2008-2009)

Chart 2: Nominal Effective Exchange Rate for RMB (2008-2009)

100.0000102.0000104.0000106.0000108.0000110.0000112.0000114.0000116.0000

Index January 1997=100

Trade Weighted Exchange of USDSource: U.S. Federal Reserve

Weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S.

trading partners

90

95

100

105

110

115

120

125

01

-20

08

02

-20

08

03

-20

08

04

-20

08

05

-20

08

06

-20

08

07

-20

08

08

-20

08

09

-20

08

10

-20

08

11

-20

08

12

-20

08

01

-20

09

02

-20

09

03

-20

09

04

-20

09

05

-20

09

06

-20

09

07

-20

09

08

-20

09

09

-20

09

10

-20

09

Note: the RMB depreciated 7.6% in 2009

BIS NEER for RMBMonthly Averages; 2005=100

NEER for RMB


22

Chart 3: Composition of International Reserves by Currency (2008)

Chart 4: Stability of International Reserve Composition

USD64%

Pound4%

Yen3%

Swiss France0%

Euro27%

Other2%

International Reserves By Currency in 2008Source: IMF

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: IMF

Other

Swiss France

Pound

Yen

Euro

USD


23

Chart 5: Currency Swap Agreements

Chart 6: Growth of China’s Foreign Exchange Reserves in 2009

It is estimated that roughly two-thirds of China‟s reserves are held in U.S. dollar-denominated

assets

200

180

100

80

7020

Currency Swap Agreements (In RMB)

Hong Kong Monetary Authority Bank of Korea

Bank of Indonesia Bank Negara Malaysia

Central Bank of Argentina National Bank of the Republic of Belarus

1,700.00

1,800.00

1,900.00

2,000.00

2,100.00

2,200.00

2,300.00

Bill

ion

s o

f U

SD

Foreign Exchange Reserves 2009Source: PBOC


24

Chart 7: China’s Top Import and Export Partners

0

10

20

30

40

50

60

70

2000 2001 2002 2003 2004 2005 2006 2007 2008

Pe

rce

nta

ge o

f To

tal

China: Top 4 Export MarketsSource: EIU

Export market 1 - USA Export market 2 - Hong Kong

Export market 3 - Japan Export market 4 - South Korea

0

10

20

30

40

50

60

2000 2001 2002 2003 2004 2005 2006 2007 2008

Pe

rce

nta

ge o

f To

tal

China: Top 4 Import MarketsSource: EIU

Import market 1 - Japan Import market 2 - South Korea

Import market 3 - Taiwan Import market 4 - USA


25

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